If you’re a day trader and you’re actually making trades instead of just planning or talking about it, then you already have a margin account.
If you are just planning or talking about it, then you’ll need a margin account before you can step into the world of day trading for real. Because you can’t day trade without one.
So what is a margin account?
At it’s most basic level, a margin account is nothing more than a loan. One that’s secured by the assets within an account, just like a house becomes the security backing a mortgage loan, for example.
The investment firm that holds and manages your account will actually loan you money against those existing assets – known as equity – and it happens without filling out an application every time you need money. In that respect it’s like a line of credit, only with much stricter parameters. Once you are approved for trading on margin, the loan happens automatically when the scope of your purchases exceeds the sum of your assets.
Like any loan, margin balances accrue daily interest, usually at a rate that roughly compares with auto loans – higher than home mortgages, but lower than non-secured consumer loans. The interest is charged to your account and thus impacts the margin balance and the equity in the account.
Here’s how it works.
Let’s say you hold $50,000 in stocks in a margin-eligible account (note: not all accounts are margin eligible, they are a specific type of account for which you must be pre-approved). If you want to buy and sell securities within that account, but without contributing the cash to do so or selling off any of your existing assets in the account, you can make the trades using margin.
Lets say you want to purchase $10,000 worth of stock. With a margin account you’ll execute the trade as you would any other (again, you need no trade-specific approval as long as your account is margin eligible and the balances are within specific parameters), and the firm loans you the money to pay for it. Form your point of view the trade goes down no differently than any other.
That loan balance is reflected within your account as a separate line item. You’ll see that you now own $60,000 worth of stock – the pre-existing $50K of assets plus the new $10K worth of stock you just bought – and that you have a margin balance of $10,000. Your equity in the account is still $50,000.
But perhaps not for long. Because when the price of the securities in the account go up or down, the entire equity formula changes right with it.
Let’s say the price of the stock you just bought goes down by 50%, to a value of $5000. You still owe the $10,000 you borrowed to buy it, but now the total value of the stocks in your account is only $55,000 (assuming the original stock didn’t go down, too… which it probably did if the new stock tanked that quickly). Which means your equity is now only $45,000.
Margin Rules
In order to avoid a repeat of the day trading chaos of ten years ago, new rules about margin equity have been put in place to make ensure traders don’t over-extend themselves.
They are complicated, requiring a minimum equity of $25,000, with immediate constraints implemented the moment you fall below that number and limits on the amount of trades you can execute. Which can happen quickly if you’re trading close to that line and the market doesn’t go your way.
And in that sense day trading hasn’t changed at all. It’s still a game best played by the experienced and the risk averse. Only now, it’s a game governed by margin account rules that you need to understand before you stop talking about it and actually get on the field.
